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May 2008

05/25/2008

In the mid-1990's Mexico started an anti-poverty program, called Progressa, that revolutionized the way low income countries try to reduce child labor and the school dropout rate. This new approach typically pays poor parents to keep their children in school and to take them for regular health check-ups. The reasoning motivating this approach is that while poor parents may love their children as much as rich parents do, the need for greater income induces poor parents to take their children out of school, so that they can go to work and add to the family's income. Offering monthly cash payments if the children remain in school and performs well instead of going to work helps compensate these families for the loss in their children's earnings.
The results of Progressa are publicly available so that they can be objectively analyzed, and compared with a control group of similar families who were not invited into the program. Studies by economists in the United States and elsewhere clearly show that Progressa has succeeded in inducing the mainly rural parents in the program to keep their children in school longer than they would have. The budgetary cost of that achievement has been sizable; although the cost would have been much less if Progressa had offered the subsidies mainly to parents with children at the ages-usually when children were in the 6-8 grades-when poor rural Mexican parents typically took their children out of school.
For many years I have enthusiastic about using incentives to encourage greater school attendance by children from poorer families. I first wrote about Progressa, and similar programs in Brazil and elsewhere, in a Business Week article entitled " 'Bribe' Third World Parents to Keep Their Kids in School", Nov. 22, 1999. Such programs seem to be the most effective way to induce poor families in developing countries to reduce child labor by keeping their children in school much longer. Prior to the introduction of these programs, poor parents simply ignored laws against child labor, and those requiring children to stay in school until they either reached a certain age or attained a minimum grade level.
Until recently, programs similar to Progressa had spread to many countries, but all of them were low to moderate income countries. However, within the past year, New York City and a few other American cities have started experimental programs to adapt the incentive concepts behind Progress to the situation of poor families in the United States. The New York experiment is fully funded by private foundations and individuals, including Mayor Bloomberg- I will concentrate my discussion on this city's program. Since the children involved are older than those in Progressa, they rather than their parents are paid for good attendance and for raising their test scores. Their parents are also paid to improve the choices they are more directly responsible for, such as working longer hours, and taking their children more frequently for health checkups.
It is obviously too early to evaluate the benefits and costs of the New York experiment, but I am confident that it will raise the performance of the students participating. The reason is simply that boys and girls as well as adults respond to incentives, as every parent realizes time after time. Rewarding these poor students for better performance is similar to the tuition scholarships and stipends that colleges award to students with good grades. To earn the "pay" offered, students involved will skip school less often. They will also pay closer attention to their teachers during classes and do more homework, so that they can do better on the standardized tests that are being used to judge their performance. Whether this particular experiment has the most effective link between rewards and increase in performance on these test will only be clear with further experimentation, but a pioneering program of this kind has to start somewhere.
The New York program is not without many critics, which perhaps explains why it has been funded privately rather than by public resources from tax revenue. Some critics believe it is wrong to pay children and parents to do what they should want to do anyway in their own self-interest since doing better in school will be valuable in getting good jobs when they are young adults and enter the labor force. Most high school students do in fact recognize the importance of doing finishing high school and doing reasonably well, but the New York program is directed precisely to those who are performing badly, perhaps because they heavily discount the future, or are in dysfunctional families. Other critics content that change has to start with these dysfunctional families that are responsible for their children skipping school and their poor school performance. The family is surely important to the achievements of children, but children from these families and their mothers can still do much better now if they are given strong financial incentives to do so.
Another set of criticisms does not deny the importance of incentives to poor families and their children in rich countries like the United States. However, it argues that the existence of incentive programs, such as in the New York experiment, will encourage some children who have been doing well to lower their school performance, so that they can qualify for the program. All incentive-based programs with income or other cutoff points induce some families to change their performance to better qualify for the programs. One has to be mindful of this effect in designing a program for poor parents and their children to make sure that that it is not so generous as to attract many more families to qualify by worsening their performance. I believe that this is a greater problem with the payment system to parents than that to children, but further experience will inform us about that.
Yet such possible risks are no reason to delay incentive-based programs until families become less dysfunctional, or their children become more aware of the future benefits of better school performance. Too many children, especially of African-American and Hispanic backgrounds, are doing so badly in school, and they are dropping out of school in such large numbers, that we should be willing to try an approach that has been successful in developing countries. I commend New York for being willing to take initial steps in the direction of offering financial incentives to badly performing students that encourage them to work harder to get more out of their education .

The Mexican and New York City programs are well described in Becker's post and in a recent article in the Financial Times by Christopher Grimes, "Do the Right Thing," May 24, 2008, www.ft.com/cms/s/0/a2f1b24a-292a-11dd-96ce-000077b07658.html?nclick_check=1. I cannot comment on the Mexican program; nor do I oppose social experiments financed by private money, as in New York. But I am skeptical about the New York program, and if I were a New Yorker I would be reluctant to support public financing of it.
Before Milton Friedman proposed to replace welfare programs with a negative income tax--that is, a cash grant with few if any strings attached--welfare programs were in part devices by which the government endeavored to buy good behavior from the poor. Hence food stamps, but not food stamps that could be used to buy liquor. Or money earmarked for health or education.
Friedman's criticism of such programs was that people have a better sense of their needs than government bureaucrats, so that if the government simply gave poor people money they would allocate it more efficiently than the welfare bureaucracy would do. This philosophy was eventually adopted by the federal government in the form of the earned income tax credit. The danger in giving the poor money (or anything else for that matter) is that it will reduce their incentive to work; this problem was addressed by the replacement of welfare by workfare at the state and later the federal level.
Friedman's analysis requires qualification, however, when the issue is the welfare of children. The reason is that not all parents balance their own welfare with that of their children in an impartial manner. That is why we have laws forbidding child neglect and abuse. It is also why we have compulsory-schooling laws and forbid child labor. These are paternalistic laws in a quite literal sense, but are justified to the extent that there is legitimate concern that not all parents are faithful agents of their children. Nevertheless, as a general rule parents both know better than welfare officials what is good for their children and love their children more than the officials, however well meaning, do, so any proposal to expand the role of government in controlling children should be viewed with caution.
Public school is both free and compulsory, and schooling adds considerably to a child's lifetime income prospects, so we must ask why some parents do not compel their children to attend school regularly. One reason might be that some of them do not value their children's welfare. Another that they cannot control their children. And a third that they do not think their children benefit significantly from regular attendance. I would guess that the second and third reasons are more common than the first.
Paying children to go to school would probably have at least some effect in countering all three cases. However, the benefits would be limited to children who, but for the payment, would attend school less frequently. I do not know how those children could be identified in advance, which means that the program would confer windfalls on some, perhaps many, children. (It would be odd to disqualify children on the basis of their good attendance!) In addition, there would be substantial costs, both direct and indirect, to the program. The direct costs would consist of the costs of distributing the money to the kids, making sure that it is not appropriated by the parents, and monitoring the children's school attendance. (So: more bureaucracy.) The indirect costs would include perverse incentive effects--some parents would spend less on their children to offset the payments that the children would be receiving for staying in school. Also, giving children their own source of income would reduce parental control and by doing so weaken already weak families. And some children contribute more to family welfare by occasional truancy than by consistent school attendance--for example, they may be older children helping to take care of younger siblings in households in which the parents work full time, or in which there is only one parent. Also, how does one end such a program? If the payments are suddenly withdrawn, will the kids feel aggrieved and resume truancy with a vengeance?
The largest indirect cost, I would guess, would consist in relaxed pressure to improve the public schools or to allow them to be bypassed by means of voucher systems. High rates of truancy may be due in significant part to low quality of schools. Paying children to attend school will reduce truancy rates some but without improving school quality, and perhaps without improving the education of the children receiving the payments. (School quality may actually decrease, with more crowded classrooms--crowded by kids who don't really want to be there.) Suppose that a school is in session 200 days a year, a student is truant 10 of those days, and if paid to attend would be truant only 5 days. Then the effect of the payment would be to increase the number of days the child was in school by only 2.5 percent. If it's a bad school, there might be zero benefit from this modest increase in attendance.
Granted, there are many children in New York who are truant for much longer periods. An article by Harold O. Levy and Kimberly Henry, "Mistaking Attendance," New York Times, Sept. 2, 2007, www.nytimes.com/2007/09/02/opinion/02levy-1.html?_r=2&ex=1189396800&en=1d2692cb89c474d7&ei=5070&emc=eta1&oref=slogin&oref=slogin, estimates that 30 percent of New York public school students miss a month of school every year. But they may be children who for mental or psychological reasons, or extreme family circumstances, cannot benefit significantly from additional schooling. The beneficial effects of paying children to go to school are likely to be concentrated on the kids who are casual rather than extreme truants, and those benefits, as suggested by my numerical example, may be slight.
Another component of the program is paying children for performing well on standardized exams. Such measures reward work more directly than paying for attendance, and also avoid the bad signal that is emitted by bribing people to do what the law requires them to do (i.e., attend school until 16 or 18, depending on the state), but they may largely reward intelligence rather than study. Working hard in school is no guaranty of getting good grades. Scholarships for promising students and awards for high performance have good effects, but the paid students are unlikely to qualify in competition with students who do not have to be paid to attend school.
Paying children to attend school is a band-aid approach at best. Far better would be a voucher system that would create competition among the public schools to serve children better.

05/18/2008

The subprime mortgage debacle, efforts by New York City to ban trans fats in restaurants, the discovery of lead in toys manufactured in China, and concerns about safety inspections of airplanes and laxity in regulation of new drugs have brought to the fore the issue of the optimal scope and methods of regulation designed to protect consumers.
There are two reasons to think that consumers might need more protection than is provided by competition among sellers, even as backed up by court-enforced law. Few opponents of regulation doubt the appropriateness of such judicially enforced rules as the implied warranty of fitness and safety that accompanies the sale of products.
The first reason for thinking that it might make economic sense to add a layer of regulation to competition plus court-enforced law is the high costs to consumers of obtaining information about products and services (but I will confine my attention to products). The busier people are and hence the higher their costs of time, and the more complex that products are, the higher consumer information costs will be. Product information could be thought a product in itself that a competitive market would generate in optimal quantities, but that is far from certain. The problem is what might be called "fouling one‚Äôs nest." If a cigarette producer advertises its cigarettes as "safer," it is implying that cigarettes are unsafe, and this could reduce consumption. Now in fact everyone knows about the dangers of smoking, so that is not a serious problem; but it is a problem when the hazards of a product are not widely known. A restaurant that advertises that its food contains less trans fat or less salt than other restaurants is telling consumers that there are bad things in restaurant food. Moreover, and probably more important, it is very difficult for an advertiser to explain why trans fat or salt or butter is bad for one. I believe that the obesity epidemic must be due in in part to the ignorance of many consumers, especially if they are poorly educated, of the causes and consequences of obesity.
There are three possible responses to the problem created by consumer information costs. The first is to require producers to provide more information; the second is to ban products upon on the basis of a judgment that if consumers knew the score they would not buy the product in question; and the third is to leave the burden of information on the consumer, thereby increasing the incentive of a consumer to inform himself about the products he buys. Often the preferred ranking will be 2, 1, and 3. Banning the product eliminates information costs, though to justify so drastic a measure requires a high degree of confidence that informed consumers would not buy the product if they knew the facts about it. If as I believe trans fats have close and much more healthful substitutes that cost little more than trans fats, the attempt to ban trans fats in New York City restaurants made sense.
Forcing sellers to provide more information to consumers can paradoxically raise consumer information costs by requiring consumers to sort through more warnings and interpret and evaluate them. There is also a lulling effect: required warnings create the impression that the government is protecting consumers by regulating sellers, which it may not in fact be doing; or may create resentment because consumers feel overloaded with unnecessary warnings: a "crying wolf" problem. A related problem is that consumers have very different stocks of information, making it difficult or even impossible to draft a warning that will provide a significant net increment in consumer knowledge.
Finally, encouraging consumers to become better informed about products on their own, in lieu of relying on government regulation, might be excessively costly. It would force consumers with high time costs to reallocate high-value time to the study of consumer products, at a cost and a cost of this reallocation that might exceed the cost of regulation. Take the case of health inspections of restaurants. My guess is that those inspections add little to the cost of restaurant food (I am assuming the inspections are financed by a restaurant tax). In their absence a consumer could not just drop in on a new restaurant with confidence that he would not get sick because of unsanitary conditions. (So such regulation may encourage entry into the restaurant industry.) No doubt services would spring up to rate the healthfulness of different restaurants, just as services like Zagat rate the quality of the food and service offered in different restaurants. But the inspectors employed by a private service would not have the powers of public inspectors--to inspect without notice and shut down a restaurant found to have unhealthful conditions. Perhaps some restaurants would consent to grant such powers to a private service, but then the consumer in evaluating the private inspection services might be faced with a formidable search cost to determine the best service.
Apart from costs of obaining information, there is the distinct problem of evaluating or processing information. This is the domain of the cognitive quirks that have been illuminated by the recent literature (increasingly influential in economics) in cognitive psychology. An example is the seeming inability of many consumers to appreciate the practical identity between an item priced at $9.99 and the identical item priced at $10.00. Merchants' unquestionably sound conviction that consumers exaggerate the difference between these two prices is the only thing keeping the penny in circulation, as it costs more than a penny for the U.S. Mint to produce a penny.
I do not think these quirks provide a compelling reason for additional regulation of consumer products and services. Such regulation would amount to telling consumers that they can't think straight, and would reduce consumer utility, at least in the short run, by denying them $9.99 "bargains." I would however favor incorporating into the curricula of high schools, and perhaps even elementary schools, courses in cognitive psychology that would make students alert to the pitfalls that await them as a result of cognitive defects that, though hard-wired in the brain, are avoidable if one is alert to their existence.
The existence of cognitive deficiencies may have been a factor in the subprime mortgage debacle, though on the consumer rather than the producer side. Many consumers may have been incapable of properly evaluating the risks of heavy borrowing; cognitive psychologists have found that average and even very intelligent people have difficulty handling probabilities. On the producer side of markets, however, there are forces for minimizing the effect of cognitive deficiencies. People who don't handle probabilities well are not going to thrive in the insurance business or other financial businesses. They will be selected out by competition; the analogy is to natural selection in biological evolution. I suspect that the housing bubble and ensuing credit crunch reflect, on the business side of the market, not so much irrational optimism as risk taking that was rational given asymmetries of loss and gain. Generous severance benefits truncate downside risk for the top management of large companies, and speculation in the face of a known bubble can be rational because until the bubble bursts values are rising very rapidly; the trick is to jump off the hurtling train just before it crashes.

The consumer protection issue has been thrust into public attention by the housing debacle because many families have had lenders foreclose on their homes, while other home owners are in serious arrears on their mortgage payments. Ye neither consumer ignorance nor cognitive defects in consumer decision-making had much to do with the housing bubble. Many home owners with low education and earnings, and with limited financial acumen became homeowners toward the end of the bubble period. They tended to lose little from the bubble since they put almost no money down, and they were given low ("teaser") interest rates on their mortgages. They frequently walked away from their homes when prices dipped below the value of their mortgages, and lost little.
On the other hand, highly sophisticated lenders, including giant companies like Bear Stearns, Citibank and UBS, lost billions of dollars through paying too much for their mortgage-backed securities. Many top executives of these banks were out millions of dollars because they owned lots of shares of their companies, and they had generous options that went under water. Government regulators, not private incentives, created the important asymmetry between gains and losses to the executives of these companies. Financial leaders know that when many banks get into financial difficulties at the same time, the "too large to fail" principle of bank regulators would be applied, so that equity owners would be at least partially bailed out. Bear Stearns' equity investors lost a lot when JP Morgan purchased the company, but they would have lost more if the Fed had not guaranteed $29 billion of BS assets.
The consumer ignorance and cognitive defects stressed by Posner did not cause the housing bubble, for it was due to a belief that rising housing prices and the general good times would continue for much longer. Allan Greenspan, probably the greatest central banker of the past several decades, recognized that it is not easy to distinguish legitimate increases in prices from excessive price increases. The fact is that during price bubbles, regulators, including central bankers, usually get caught up in the same optimistic frenzy that drives participants. How would greater regulation have helped when commercial banks, one of the most heavily regulated of all industries, did so badly during this housing bubble?
I am not trying to deny that consumers often have very imperfect information about the products they buy, but they do not have to rely only on their own information. The advantage to companies of getting and maintaining their reputations as they compete for consumers is a powerful regulator of the quality of products that consumers receive. Shoppers, for example, rely on Whole Foods, Safeway, and other supermarkets to do much of the information processing for them, and consumers hold the supermarkets responsible for bad-tasting foods, and other products that do not live up to claims of their suppliers. It is not the diligence of regulators but the reputations of companies that are mainly responsible for all the high quality merchandise consumers purchase without having to know all the details.
I agree with Posner that companies do not want to "foul their nests", but still companies have had no hesitation in saying that they do not use trans fats-a purely voluntary provision of information to consumers not required by regulations- or that their cereals use oats that may be good for the heart, or that their products are lower than before in salt and fat, or that their airlines have better on-time records or more comfortable seats than competitors, or that their cars have better repair records or better hold their value as they age than cars of competitors, or that their drugs can prevent erectal dysfunction, lower cholesterol levels, treat pain better because of more powerful ingredients than in the past, or have other positive effects on the health and pleasure of consumers.
Posner seems to believe that consumers have less information than in the past because their time is more valuable and they are busier. Their time is more valuable in large measure because they have greater levels of human capital that increases their skills, and enables them to use and process information more effectively. The Internet has also made an enormous difference in enabling consumers to acquire information more easily, whether through offering comparisons of hotel rates and prices of cars being offered for sale, or through the provision of information about effectiveness and side effects of different drugs and medical procedures. The same factors that make time more valuable to consumers make it easier for them to acquire and process information about the products they buy.
Various groups have pushed in recent years for greater regulation of all types of consumer choices, including smoking, eating of fast foods, the ingredients allowed in foods, such as trans fats, the drinking of alcoholic beverages, and many other products and services. This pressure toward greater regulation of consumer choices is not the result of consumers finding it more difficult to get information about products and the consequences of consuming them. Nor have the cognitive defects referred to by Posner become more prevalent or harmful. Instead, the movement toward increased regulation of consumer choices reflects in large measure greater reluctance among some groups to accept these choices. It is unacceptable to many persons both inside and outside the medical profession that some individuals want to smoke or eat a lot and become overweight, even if they knew and possibly exaggerate the negative health consequences of smoking and overeating. The increase in weight of teenagers, for example, is not explained by cognitive biases, but by sharp declines in the cost of fast foods, and the development of Internet and other sedentary games.Increasing intervention in consumer choices also reflects the erosion of individual responsibility (see my discussion on March 16), so that consumers and their advocates blame others when consumer choices turn out to be harmful and costly.
I do not deny that regulations may be required when the consequences of mistakes are very serious, and when the forces unleashed by competition provide inadequate protection. One example is the permissibility of lawsuits against surgeons who make obvious mistakes during their surgeries, such as leaving sponges in a patient's body. Another possible example is the regulation of airline safety, although airlines suffer a lot when they have accidents, regardless of regulatory measures, and government safety regulations have often been inadequate and misleading.
Important exceptions notwithstanding, the overall trend toward greater regulation of consumer choices is disturbing. Consumers make worse decisions when they are not responsible for their decisions, or when they can sue or otherwise get compensated when they make bad decisions. Consumers make mistakes, but they learn from them when they have to bear the consequences of their decisions. They are generally far more competent to make decisions in their own interests than are regulators or lawmakers as long as consumers are the ones who benefit from good choices and are hurt by bad choices. This is why I continue to be a minimalist on government regulation, and greatly prefer the controls over behavior that stem from consumer responsibility and the discipline of competition.

05/11/2008

The run-up in the world price of oil during the past several years, and especially the rapid climb during the last few weeks to over $120 per barrel, has fueled predictions that the price will reach $200 a barrel in the rather near future. Such predictions are not based on much analysis, and mainly just extrapolate this sharp upward trend in oil prices into the future. The price of oil in "real" terms (i.e., relative to general prices) will not reach $200 in this time frame without either terrorist or other attacks that destroy major oil-producing facilities, or huge taxes on oil consumption. I try to explain why in the following.
The two previous sharp increases in the world price of oil, in 1973-4 and 1980-81, were due to supply disruptions. The first one was the result of the formation of OPEC that led to output restrictions by members of this cartel, while the later one was due to the Iran-Iraq war that curtailed petroleum production in these two countries. Although the world price of petroleum rose by a lot in all three episodes, worldwide oil production went down in the two earlier ones, while production has risen during the current price boom. The present boom in oil prices has been mainly driven by increases in demand from the rapidly growing developing nations, especially China, India, and Brazil, although output growth in the US and European have added to world demand, and speculation on potential future price increases also contributed to the increased price of oil. To be sure, supply problems in Nigeria, Venezuela, Russia, and other major oil-producing states have contributed to accelerations in the oil price increases at times during the current boom.
Note the contrast between the major causes of the current explosions in oil and food prices. Although the sharply rising prices of different commodities are often lumped together, increases in the prices of corn and other foods have in larger part come from the supply side rather than from demand. The main supply culprits in the market for foods have been the diversion of corn acreage to the production of ethanol, and the increased cost of fertilizers and chemicals used in food production due to the rise in the price of oil (see my discussion of rising food prices on April 13 and 17).
The rapid growth of world oil prices during 1973-74 and 1980-81 contributed in a significant way to the world recessions during those years. Yet even though world oil prices in real terms are now above the prices in 1981, the previous peak in oil prices, and despite the sharp run-up in prices during the past couple of years, the world economy has not (yet!) been pushed into recession. One reason for the difference is that unlike the previous episodes, the current price rises have slowed rather than eliminated the boom in world output. Another difference from the previous episodes is that the share of oil and other energy inputs in GDP is down by a lot in the developed world since 1980, especially in Japan and Europe, but also in the US.
Of course, even with energy's smaller role in the production of output, any rise in oil prices to over $200 a barrel in the next few years would have serious disruptive effects on the world economy. To many persons who have commented on this prospect, such a high oil price seems plausible, given the expected continuation of the rapid growth in the GDP of China, India, Brazil, and other major developing countries. For the evidence is rather strong that the short run response of both the supply of and the demand for oil to price increases is rather small. The small elasticity of both the supply and demand for oil explains why the moderate reductions in world oil supply during the earlier price spikes, and the moderate increase in world demand during the current price boom, produced such large increases in price.
However, the long run response to price increases of both the demand and supply for oil and other energy inputs is considerable. For example, given enough time to adjust, families react to much higher gasoline prices by purchasing cars, such as hybrids and compacts, that use less gasoline per mile driven. They also substitute trains and other public transportation for driving to work and for leisure purposes. High energy prices, and hence the opportunity for large profits, induce entrepreneurs to work more aggressively to find fuel-efficient technologies, including the use of batteries as a replacement for the internal combustion engine.
Clearly, given high enough oil prices, many ways are available to increase the supply of petroleum, Explorations for additional supplies will be extended deeper into oceans and other remote places because the high cost of extracting oil from these sources would be offset by the high energy prices. Usable petroleum is also already being extracted from oil sands and oil shale, and high and rising oil prices will speed up and extend this process. The reserves of tar sands in Canada and Venezuela are huge; indeed, Canada is getting much of its oil production from this source. Oil shale is also abundant in several places, including the United States, and while extraction of petroleum from shale is expensive and complicated, the high prices have induced some countries to start doing this.
Rising prices of oil and other energy inputs will eventually be controlled by new technologies that greatly economize on the use of these inputs. Increased supplies of oil and other energy sources that become profitable to exploit only with prolonged high prices will also push these prices back.

As Becker explains, we cannot predict the future price of oil. But it is unlikely to rise in the foreseeable future to $200 a barrel, especially if we think in inflation-adjusted terms. Oil prices in real terms have fluctuated a great deal. In December 2007 dollars the price of oil was below $20 in 1946, above $100 in 1979, and only about $10 a recently as 1998. High prices affect both demand and supply; the recent price peaks have already reduced demand for gasoline in the United States and increased efforts to discover and exploit new oil fields. The United States has large untapped oil reserves both offshore and in Alaska, and there are many other untapped reserves elsewhere in the world. Supply is responding to the high price of oil and will respond more. If Iraq ever stabilizes, its output of oil will increase. Were the world price of oil to rise to a level close to $200, both demand and (with a lag) supply would respond. Oil trapped in sand and shale--a potentially very large supply--would become economical. In the longer run, very high oil prices will further stimulate the development of alternative fuels.
Major political or natural catastrophes could of course alter the picture. Middle eastern oil supplies are vulnerable to the ever-present threat of war in that region, and the oil industries of Venezuela, Nigeria, and possibly even Saudi Arabia are vulnerable to political unrest, civil war, or terrorism.
I would like to see the price of oil rise to $200, despite the worldwide recession that would probably result, provided that it rises as a result of heavy taxes on oil or (better) carbon emissions. The taxes would jump start the development of clean fuels, and the financial impact on consumers could be buffered by returning a portion of the tax revenues in the form of income tax credits. That would not reduce the effect of the taxes on the demand for oil or the incentives to develop alternative fuels, because the marginal cost (the production and distribution cost plus the tax) of oil to consumers would not be affected. Higher oil prices are necessary to check global warming, reduce traffic congestion, and reduce dependence on foreign oil, so much of which is produced by countries that are either unstable or hostile to the United States. Heavy taxes on oil would reduce not only the amount of oil we import but also the revenue per barrel of the oil exporting nations, so there would be a double negative effect on those countries' oil revenues: they would sell less oil and earn less per unit sold. The reason for the latter effect is the upward-sloping supply curve for oil. Suppose the first million barrels of oil can be produced at a cost of $1 per barrel and the second million at $2 per barrel. If total demand is one million barrels, the suppliers break even: they have revenues of $1 million and costs of $1 million. If total demand is two million barrels, the suppliers have revenues of $4 million (because the price of all barrels is determined by the price that the marginal purchaser is willing to pay) but costs of only $3 million ($1 million for the first million barrels, $2 million of the second). The lower the price of oil received by the oil producers (that is, the price net of tax), the lower their net income.
Unfortunately I cannot see a confluence of political forces that would make heavy taxes on oil feasible. We seem to be experiencing a democratic failure, in which long-term problems simply cannot be addressed.

05/04/2008

The President has expressed dissatisfaction with the proposed Farm Bill wending its way through Congress. He wants farmers whose annual incomes exceed $200,000 to be denied subsidies; the present cutoff is $2.6 million and Congress will not go below $950,000. The President's concern with farm subsidies cannot be taken very seriously, since in 2002 the Republican Congress with Administration connivance greatly increased these subsidies and at the same time repealed some of the modest reforms that the Clinton Administration had introduced in 1996. The Administration's current proposals would, if enacted, be a step in the right direction, but they will not be enacted, and, judging from the 2002 legislation, they are intended I suspect merely to embarrass the Democratic Congress.
The deregulation movement passed agriculture by, leaving in place a series of government programs that lack any economic justification and at the same time are regressive. They should offend liberals on the latter score and conservatives on the former; their firm entrenchment in American public policy illustrates the limitations of the American democratic system. A million farmers receive subsidies in a variety of forms (direct crop subsidies, R&D, crop insurance, federal loans, ethanol tariffs, export subsidies, emergency relief, the food-stamp program, and more), which will cost in the aggregate, under the pending Farm Bill, some $50 billion a year, or $50,000 per farmer on average. Farm subsidies account for about a sixth of total farm revenues. So, not surprisingly, the income of the average farmer is actually above the average of all American incomes, and anyway 74 percent of the subsidies go to the 10 percent largest farm enterprises. The subsidies are regressive, especially during a recession coinciding with worldwide food shortages (i.e., high prices).
There is no justification for the Farm Bill in terms of social welfare. The agriculture industry does not exhibit the symptoms, such as large fixed costs, that make unregulated competition problematic in some industries, such as the airline industry, about which Becker and I blogged recently. It is true that crops are vulnerable to disease, drought, floods, and other natural disasters, but the global insurance industry insures against such disasters, and in addition large agricultural enterprises can reduce the risk of such disasters by diversifying crops and by owning farm land in different parts of the nation and the world. If a farm enterprise grows soybeans in different regions, a soybean blight in one region, by reducing the supply of soybeans, will increase the price of soybeans, so the enterprise will be hedged, at least partially, against the risk of disaster. Supply fluctuations due to natural disaster create instability in farm prices, but farmers can hedge against such instability by purchasing future or forward contracts. There is no "market failure" problem that would justify regulating the farm industry. All the subsidies should be repealed.
This of course will not happen, and that is a lesson in the limitations of democracy, at least as practiced in the United States at this time, though I doubt that it is peculiarities of American democracy that explain the farm programs, for their European counterparts are far more generous. The small number of American farmers is, paradoxically, a factor that facilitates their obtaining transfer payments from taxpayers. They are so few that they can organize effectively, and being few the average benefit they derive (the $50,000 a year) creates a strong incentive to contribute time and money to securing the subsidies. The free-rider problem that plagues collective action is minimized when the benefit to the individual member of the collective group is great. Then too many of the members of the farm community and hence recipients of the subsidies are wealthy, and the wealthy have great influence in Congress as a result of the lack of effective limitations on private financing of congressional campaigns and on lobbying generally. In addition, the allocation of two senators to each state regardless of population enhances the political power of sparsely populated states, which tend to be disproportionately agricultural. The key role of Iowa in the presidential electoral process is a further barrier to the abolition of farm subsidies, and the final factor is the alliance of urban with farm interests in support of the food-stamp program, itself inferior to a negative income tax, which would give the poor money but allow them to make their own consumption choices.
A puzzle about the farm programs is the heavy emphasis on money subsidies, since by reducing the cost of farming they encourage greater output, which results in lower prices for farm products, thus offsetting some, perhaps much, of the effect of the subsidies. (The lower prices are not a social benefit, because as the result of subsidization they are below cost.) Acreage restrictions, which used to be the core of federal farm policy, and which correspond to the type of entry-limiting regulations imposed on airlines, railroads, trucking, pipelines, long-distance telecommunications, banking, and the wholesale sale of electricity, before the deregulation movement, are more efficient at raising farmers‚Äô incomes by reducing output, in effect cartelizing agriculture. Those restrictions have been reduced, but between them and export subsidies (which reduce the supply of agricultural products to American consumers) farm prices in America are higher than they would be without the farm programs, and this contributes to the regressive effects of the programs.

Posner presents evidence on the sizable subsidies received by American farmers from the federal government of the United States. However, the US is not unique, for every rich country including France, Germany, Great Britain, and Japan, heavily subsidizes their farmers, no matter how small the agricultural sectors. In fact, some of these other countries subsidize farmers more generously than even the United States. On the surface, this universal tendency for rich countries to subsidize farming, no matter how different are the details of their political systems, is a paradox. For since only a small fraction of the populations of these countries work in agriculture, farmers cannot contribute much to any majority voting coalition.
Add to this paradox that pretty much every developing country, no matter whether they have democratic or totalitarian political systems, rather heavily tax farmers in order to subsidize their urban populations. Taxing of farmers is as true of India as of China, Mexico as well as Argentina, Egypt as well as South Africa, and similarly for the other poorer nations. In all these countries, farmers are a significant fraction of their populations, and they form a majority in many, such as India and China.
This different treatment of farmers in rich and poorer nations is dramatically seen in the causes of and the responses to the recent worldwide explosion of food prices. American and European subsides to biofuels are an important factor behind the rise in food prices, for these subsidies directly raised the price of corn to consumers, and indirectly raised the prices of other grains (see our recent discussion on April 13 and 17 of the rise in food prices). Riots broke out in many cities around the world in protest against the increases in the prices of bread and other food stables. To quell these riots and other urban unrest, many countries restricted their exports of agricultural goods in order to lower the prices and increase the supply of these goods to their urban citizens. The effect of these export restrictions was to lower the incomes of the farmers in these countries since they were prevented from selling some of their produce on the world market where prices are higher.
This response to rising food prices by the governments of poorer nations is not explained by any concern about fighting poverty in these nations. The fact is that farmers in developing countries are much poorer on average than are their city residents, which explains the continuing migration from the rural areas to cities in these countries. So by putting restrictions on the exports of farm goods, developing countries are not only making their economies less efficient, but also they are adding to the overall incidence of poverty among their populations. The gap between the incomes of rural and urban families is much smaller in developed countries that subsidize rather than tax farmers. Indeed, with the high prices for cereals and other foods during the past couple of years, average farm incomes are often above those of city residents.
I believe that the explanation for the very opposite treatment of farmers in developing and developed countries is interest group competition (see my "A Theory of Competition Among Pressure Groups for Political Influence", The Quarterly Journal of Economics (Aug., 1983), pp. 371-400. This analysis shows that small groups, like farmers in rich countries, often have much greater political clout than large groups, like farmers in poorer countries. The reason is that even large per capita subsidies to small groups, such as farmers in the US, impose rather little cost (i.e., taxes) on each member of the large groups, like urban and suburban residents of the US. As a result, these large groups do not fight very hard politically against the small per capita taxes used to subsidize farmers.
By contrast, a large subsidy to farmers in developing countries would require imposing high per capita taxes on their relatively small urban populations since farmers are a rather large proportion of the total population in these countries. Instead, the same political pressures as in developed countries lead poorer countries, regardless of the nature of their political systems, to subsidize the smaller urban populations at the expense of the larger farm populations.
Hence a common approach to the political process based on interest group pressures can explain both the taxing of poor farmers in developing nations, and the subsidies to well off farmers in richer nations.